Liquidity Book - Making Liquidity Composable
Liquidity Book - Making Liquidity Composable
Concentrated liquidity comes with many improvements over the traditional constant product (i.e., x*y=k) design. It offers better capital efficiency for liquidity providers and reduces price impact for traders. However, prior to the release of the Liquidity Book, concentrated liquidity had one big flaw.
That is, it was not very composable. For example, on Uniswap V3, each position is represented by the ERC-721 NFTs rather than the fungible tokens users are used to. This not only makes Uniswap LP tokens cumbersome to manage but harms their adoption in wider DeFi.
Liquidity Book takes a different approach with specifically designed liquidity position contracts that can act and behave as normal ERC-20 tokens.
Managing Liquidity
Concentrated liquidity positions require constant attention from depositors. If they want to keep earning fees and avoid their LP becoming “inactive”, they have to adjust constantly (i.e., rebalance) price ranges. This is especially true for those who choose to provide liquidity in very tight or exotic ranges to capture maximum fees.
With NFTs, each case of rebalancing requires multiple transactions - withdrawing, redefining parameters and depositing again. This might seem like an insignificant difference at first - what are a couple of transactions in the grand scheme of things? However, because of NFT positions being represented as NFTs, users might hold multiple different ones, even for the same pair. So a couple transactions might quickly turn into four, six, eight or more, making managing liquidity a time-consuming and expensive task.
With Liquidity Book, on the other hand, only one transaction is required from the user to rebalance their position. All liquidity in bins, which are essentially constant sum pools bundled together, is fungible, so users don’t have to deal with the complexities of holding multiple NFTs.
Making choices
Even without juggling multiple transactions, deploying liquidity on Uniswap V3 is hard. To do it effectively, users must consider multiple factors, such as the current price and expected volatility of both assets in a pair. In some cases, liquidity provision on Uniswap V3 might seem like it is a full-time job that requires a degree in math or finance.
Research shows that many liquidity providers on Uniswap V3 lose money due to Impermanent Loss even when accounting for fees. Therefore, more and more sophisticated strategies have to be employed to keep the LP position profitable, making it less and less accessible for retail looking for passive and stable income.
Liquidity Book makes building custom strategies and deciding what to do with tokens much easier for regular users, thanks to its innovative bin design and liquidity tokens following the ERC-1155 standard (with ERC-721 functionality removed). Besides that, it also compensates liquidity providers for the IL through variable fees.
Plugging into DeFi
One of the strongest properties of decentralised finance is its composability. Users can deposit their LP tokens into a farm to earn more yield or into a lending protocol to unlock more liquidity. With positions represented as NFTs, this becomes hard because of how many variations are possible. One user might choose to provide liquidity for the ETH-USDC pair in the $1000-$3000 range, while another might pick the $1500-$2500 range for their position. So vaults must be built to standardise LP ranges, manage all the rebalancing, and wrap positions into fungible ERC-20 tokens. These tokens can then be used in a broader DeFi ecosystem, for example, as collateral to mint stablecoins.
Because Liquidity Book’s tokens are fungible “out of the box”, developing different vaults and protocols on top of them becomes easier. Some of them might be tailored towards people looking for something risky, with tighter ranges and risk of IL, and some - towards those who like to play it safe, with wide margins and less exposure to price spikes. The possibilities are practically endless.
Alice, the Liquidity Provider
Imagine there exists Alice, who has 1000 USDC and 20 AVAX in her wallet. She wants to earn a yield on these assets and decides that she wants to supply them to a decentralised exchange.
On a traditional AMM, this would be pretty trivial. Assuming one AVAX is worth 50 USDC, she would just need to deposit her tokens into an AVAX-USDC pair smart contract and come back to check prices once in a while. However, Alice wants to use a DEX with a concentrated liquidity model, as it wants to benefit from its capital efficiency. But how does she go about that?
First, she has to decide the prices she wants to LP, and then she has to create positions. After that, the hardest part is still ahead - she needs to constantly keep an eye on prices and rebalance liquidity as needed. The gas fees from rebalancing might even potentially eat into her profits, making the whole thing not worth it.
Or instead, she can deposit tokens into a vault built on top of the Liquidity Book, which would take care of all these issues instead. It would deploy and rebalance liquidity for her, and all fees would be socialised (i.e., shared among vault participants).
Conclusion
While Uniswap V3 certainly brought a lot of innovation with its implementation of concentrated liquidity, it also made liquidity provision something that only whales, DAOs and institutions can do reliably. Between making moving liquidity hard, requiring an understanding of complex math and finance concepts and lacking true DeFi composability, it simply becomes a “game” not really suitable for regular retail users.
Liquidity Book solves these and many other problems. It preserves the benefits of concentrated liquidity while keeping it as user-friendly as possible, so even less-sophisticated users can benefit from all of the innovations.
The liquidity book creators must be playing the game in V3. However, in spite of its risk of losses, there is a way to play v3 as a single play with no IL. If you take away all the fun we may not play your game.